Commentary

Looking for opportunities in Japan

Commentary: Betting on the recovery, using stocks, ETFs and funds

By

JoshLipton

NEW YORK (MarketWatch) — Investors, reacting to the still-unfolding crisis in Japan, are placing bets on whether stocks in that country have now fallen further than warranted or deserve their rock-bottom valuations.

In other words, will the recent events end up representing a smart buying opportunity or the start of a prolonged slump?

The Land of the Rising Sun continues to struggle with the devastating impact of a 9.0-magnitude earthquake, tsunami and nuclear crisis. Reacting to this still-fluid situation and the pronounced uncertainty, Japan’s Nikkei 225 (NI225) fell 10.2% last week.

For instance, the ProShares Ultra-Short MSCI Japan
EWV, +3.50%
saw inflows of $62 million last week, according to TrimTabs. This ETF moves double in the opposite direction of the Japanese market.

Still, while acknowledging the risks, other strategists and money managers argue that those bearish on Japan are making a mistake: Many of these Japanese companies are now attractively valued and, barring worst-case scenarios, offer significant upside potential. Also, they say precedent suggests that the Japanese economy could bounce back faster from this crisis than some pessimists posit.

For one, say the optimists, Japanese equities are cheap. Indeed, if investors are looking for value, said Gluskin Sheff’s David Rosenberg, then they should take a look at Japanese stocks. This was true before the massive tsunami and earthquake, he said, and just as true now.

“Yes, [gross domestic product] is about to take at least a 2% hit, but keep in mind that the Japanese stock market more than fully reflected that prospect at midweek when it slid 20% in what was the worst decline over such a short time frame since the 1987 crash,” Rosenberg wrote.

Alexander Young, S&P’s international equity strategist, pointed out that the Nikkei trades at a price-to-book value of 1.2. The comparable ratio for the Standard & Poor’s 500 Index
SPX, -0.55%
is 2.1. [Book value refers to assets less liabilities.]

“The bottom line is that, barring Chernobyl-like devastation where the economy goes off the grid for many months, the current selloff, we think, more than discounts the short-term economic disruption,” Young said, although he’d argue that, after the bounce-back in the past few days, the market now looks “fairly valued” overall.

Robert Taylor, co-manager of the $7.8 billion Oakmark International Fund
OAKIX, -0.58%
favors Japanese equities given what he considers their attractive valuations, improving operational performance and better corporate governance.

“We see more free cash flow returned to shareholders via buybacks and dividends,” he said. “The blue-chip companies there, such as Toyota
TM, -0.77%
(7203), Canon
CAJ, +0.41%
(7751) and Honda (7267)
HMC, -0.45%
are doing better things with their capital because they realize shareholders are a key component. That’s what has changed in Japan.”

Taylor pointed out that, in Japan, the average return on equity [a key measure of profitability comparing profits to invested equity] in the early 2000s was about 3%. In 2007, before the Great Recession started, the average ROE was over 10%.

“When you have cheap valuations as well as management doing better things with capital, then that is an exciting combination,” said Taylor, whose five-star fund has about 20% of its holdings in Japan stocks.

Taylor has no direct exposure to Japan’s insurance, energy or utilities sectors, which appear to be notably vulnerable in the short term. Top 10 holdings in the fund include Toyota and Canon.

More broadly, other analysts also suggest that precedent could give investors some reason for cautious optimism.

Analysts at Nomura Securities, the largest investment bank in Japan, argued in a recent research note that economic activity is bound to fall in the immediate wake of the earthquake, but they expect output to recover rapidly.

As evidence for this argument, they cite what happened after the Kobe earthquake struck Japan in 1995: Industrial production fell 2.6% month over month in January 1995, the month of the earthquake, but recovered in February and was back up at its December 1994 level by March.

The sectors that performed best in the month after the Kobe earthquake were those most likely to benefit from reconstruction demand — namely construction, metal products (including bridges, construction materials, housing equipment) and glass and ceramics products. The Nomura analysts expect these sectors to perform relatively well on this occasion as well.

Investors who seek exposure to Japan have different options with specific stocks, ETFs, international equity funds and actively managed mutual funds.

Still, Morningstar mutual-fund analyst Rob Wherry argued that given the uncertainty still surrounding events in that country, long-term investors who own “plain vanilla international index funds” — such as the iShares MSCI EAFE Index Fund
EFA, -0.48%
which has an allocation of about 20% to Japan — have sufficient exposure to the country.

“That’s plenty for most Main Street investors,” Wherry said. “You would have felt the selloff last week, but you will also participate in whatever recovery occurs there.”

The analyst said those investors who want to sharp-shoot for opportunities just in Japan — and who have the cash, courage and time horizon to stomach more risk and volatility — could consider two actively managed mutual funds: Matthews Japan
MJFOX, -0.56%
and T. Rowe Price Japan
PRJPX, -0.45%

“Those managers have been investing in that part of the world for a long time,” Wherry said. “They have solid track records, and their fees are reasonable.”

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